Why the 2017 stock market crash is imminent

(Written and published originally on 15th June 2017)

The true state of the US economy

Over recent times US stocks and equities have been in a state of euphoria, only this month we have seen new record highs for the Dow, S&P, and the Nasdaq as well as Amazon shares breaching the $1,000 mark for the first time and many other large tech companies continuing their strong upward trajectory. This continued upward trend may have come as a surprise to many investors as The U.S. economy added 138,000 jobs in May, according to the Labour Department, missing a consensus estimate of 185,000 which would usually result in a slight retracement in US equities. The question therefore arises, why has the market seemingly chosen to ignore negative economic data in recent times? This lead me to research the possible reasons for this and the information that I found paints a picture of the US economy which is a stark contrast to what many believe it to be.

The truth of the matter is the US economy is in a state of disrepair from which many believe it cannot recover and that the overall demise of the world’s largest economy is inevitable. Investor sentiment over recent times has become increasingly bearish with regards to the economy and it is only a matter of time until all the warning signs manifest themselves and drag the US economy into a recession, the likes of which has never been seen in our lifetimes. While the US economy’s recovery from the 2008 recession has been very poor, the head of the Federal Reserve, Janet Yellan, has desperately attempted to instil US consumers and investors with confidence claiming that the “US economy is performing well” so well in fact that she can justify beginning to increase interest rates from their artificially low levels. The rate hike at the end of 2016 was too little and was done too late to save the sinking ship that is the US economy. Ron Paul former politician turned author when asked about the FED stated, “their control is limited and all they are doing while attempting to manipulate the economy is building bubbles and setting stage for major corrections” adding that “Keynesian economics doesn’t work, inflationism and central banking doesn’t work.” The FED’s desperation is clearly shown in figures presented by CNBC last summer: $12.3 trillion of money printing, nearly $10 trillion in negative-yielding global bonds, 654 interest rate cuts since Lehman Brothers collapsed in 2008 (1). Ron Paul believes that president Trump will be blamed for the upcoming crisis even though he is powerless to prevent it just as President Obama was not entirely to blame for the great recession of 2008 and that instead the fault lies entirely with the FED and the Keynesian economics it uses in conjunction with its excessive spending and debt.

For the majority of this article I will focus on the four most alarming signs that a major correction in the US market is imminent.

The first sign which shows that the economy is not performing as well as the FED is portraying it to be is the disparity between the unemployment figures which are reported by the media and the true values and the meanings behind unemployment figures. On the surface, the unemployment figures from the end of 2016 appear positive however after delving deeper into these figures it is clear that these figures have been reported in a biased way in order to portray the economy as one which is recovering well. The November 2016 job report stated that unemployment rate fell to 4.6% and 178k new jobs were created, this simply isn’t the case. The unemployment rate doesn’t include discouraged workers who are unable to find jobs and as a result have stopped looking and in addition, those jobs that were created are not what they seem. The unemployment rate is down as a result of record numbers of people leaving the work force (increased by 446,000 in November 2016 to reach 95.1m) (2) the actual real unemployment rate taking this into account is estimated to be nearer to 9.3% (3). The Bureau of Labor Statistics define the labor force participation rate as “the percentage of the population that is either employed or unemployed (that is, either working or actively seeking work).” The current participation rate in the USA is 62.7% and continues to struggle. The historical participation rate data is given below which shows that in October 2015 it reached 62.4%, the lowest recorded level since the 1970’s. Unemployment levels may be decreasing but this isn’t because the US economy is strong and creating well paid, secure and skilled jobs rather what can be seen is a stagnation of wage growth and an increase in demand for low paying part time jobs.

Another indicator that the US’s economy is struggling is the crippling amount of debt that consumers have. More than 70% of the nation’s GDP is from consumer spending however Americans are now in more debt than they were before the financial crisis. According to NerdWallet.com who have analysed FED statistics, over the last decade US household debt has soared 11% and now the average debt held per household is $134,643. Total household debt (including mortgages, auto loans and student loans) nationwide now equals $12.4 trillion, up from $11.7 trillion in 2010. Sean McQuay, a personal finance expert at NerdWallet, has stated that the reason for this increase in debt is the disparity in income growth and growth in expenses. Median household income has grown 28% over the last 13 years, but expenses have outpaced it significantly. For example, medical costs have increased 57% and food and beverage prices have increased by 37% in that same period (4). It is for this very reason that 66 million Americans have no emergency savings and an estimated 46 million receive food stamps.

Taking on more debt doesn’t automatically translate to economic growth, low rates were designed in principle to help kickstart the economy as banks offer cheap money so that Americans can borrow, spend, and initiate the flow of money around the economy. However, with recent rate hikes and more expected in the not too distant future so much debt that was once so cheap due to low interest rates will begin to cripple borrowers as interest rates begin to increase. The quarter-percentage-point increase in the federal funds rate in March this year will cost consumers roughly $1.6 billion in extra finance charges in 2017, according to a WalletHub analysis. The average 30-year fixed-rate mortgage is now about 4.38 percent — steadily moving further from the record low of 3.50 percent in December 2012 which may seem relatively insignificant but for a nation who are already facing higher costs of living the impact will be substantial (5). After years of artificially low interest rates the FED has finally begun to raise them albeit extremely slowly but this decision should have happened a lot sooner. Recent rate hikes are seen as a vote of confidence for the US economy but the USA still faces many global headwinds such as weak global economic conditions, high household debts and a lack of high paying jobs in its economy.

The final and in my opinion the greatest factor indicating that a massive market correction is about to take place is the fact that US stocks/equity is greatly overvalued. Many investors believe current high stock prices are due to a bubble which the FED has blown (Trump has also stated that he is aware of this). In my opinion, the current bull market was born out of frustration as the FED took income out of fixed income investments when it introduced the first round of quantitative easing and gutted interest rates. Four rounds of quantitative easing and artificially low interest rates has decimated the retirement plans of those who rely on fixed income investments such as bonds to provide steady income as returns continued to hover around the 0%. As a result the only place left for investors to park their capital was the stock market and as a result stock prices have increased over the last several years despite weak earnings and revenue growth. The current bull market is the second longest in history with valuations reaching “nose bleed territory”. According to the CAPE ratio (also known as the Shiller P/E ratio) which is commonly used to value the market, the S&P 500 is extremely overvalued. The current ratio of 30.1 is 79.2% higher than the historical mean of 16.8 and has only been surpassed twice in history, once in 1929 (reached 32.6) and the other was just before the dot come bubble in 1999 where it reached an all-time high of 44.2. This means for every dollar of earnings a firm currently makes, investors are willing to shell out $30.1 dollars to own it. Some sources believe that the S&P is overvalued by as much as 72% (6). Another ratio which reinforces this theory is the market capitalisation to GDP ratio also known as Warren Buffet indicator. 100% on this ratio means stocks are relatively fairly valued but the current level is 128.9% (only been higher twice since 1950, in 1999 it came in 153% and in late 2015 it was at 129.7%). To put the potential meaning of these figures into context the level was only at 108% before the 2008 crisis. In an interview Warren Buffet did in December 2001 he stated that “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%-as it did in 1999 and a part of 2000-you are playing with fire.”

In my opinion, this bearish view regarding the US economy is becoming increasingly widespread and this has been shown by the rapid increase in the value of cryptocurrencies. Investors are clearly rejecting the greenback as a store of value in international markets and instead are pumping large amount of capital into various cryptocurrencies. Bitcoin is the largest cryptocurrency by market capitalisation with a $34bn market cap (which has doubled in the last 3 months) and by far the most well-known however the growth in the other three largest cryptocurrencies by market capitalisation have shown even more impressive growth in recent times. Ethereum three months ago had a market cap was $1.12bn to $15.7bn (and increase of 13x in 3 months), ripple currently has a $12.9bn market cap (three months ago it’s market cap was $205m, an increase of 60 times) and NEM’s market cap rose from $56.8m three months ago to currently being $2.38bn (an increase of 20x).

We are living in a very unstable world at the moment, both economically and politically, and evidence suggests that these challenging times will continue. However, there is always opportunity in adversity and so by carefully planning and executing an appropriate strategy one may be able to profit from these excitingly uncertain times.

By Tiaan Coetzee (Finance Year 2)

References:

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